Using the Sharpe Ratio to Compare Trading Strategy Returns and Risk

Summary

The article explains the Sharpe ratio as a measure of average return above a chosen benchmark relative to return variability. It contrasts this risk-adjusted measure with annualized return alone, which can make strategies difficult to compare, particularly when leverage or market neutrality is involved. It also describes annualizing the ratio according to the strategy’s return interval and stresses that the returns and benchmark must use matching intervals.

Benchmark choice depends on the strategy; the discussion notes that a market-neutral strategy may use zero excess return after accounting for interest income. The article highlights important limits: the ratio is backward-looking, assumes a distribution that may understate skew and fat-tail risk, and can make strategies such as option selling appear attractive before rare losses occur. It says transaction costs should be included and cautions against using the Sharpe ratio alone. Suggested thresholds for a “good” ratio are presented as practical rules of thumb, not universal evidence-based standards.

Key ideas

• The Sharpe ratio scales average benchmark-relative return by the variability of returns.
• Annualization requires matching the return interval to the number of periods in a year.
• Benchmark selection depends on the strategy, and a market-neutral strategy may use zero as its return hurdle.
• Historical Sharpe ratios do not predict future performance and can obscure skewed returns and tail losses.
• Trading costs should be included, and the ratio should be considered alongside other risk measures.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.